Signs point to deflation ahead

With nearly $13 trillion in fiscal and monetary stimulus added to the U.S. financial system and economy, one would think inflation would be just around the corner.

Nope. "Sorry, but it doesn't work that way," as college students say. And these days the foe of inflation hype is no dyed-in-the-wool economic liberal.

Gary Shilling, president of A. Gary Shilling & Co. and no inflation dove, told Bloomberg Radio Wednesday that normally he would be very concerned about the enormous amount of stimulus added to the economy and credit markets. "Normally, it would be inflationary, but it's not now because the economy is shrinking by so much more it's taking more money out the system than we're putting in," Schilling said.

Sees deflation ahead

As a result, Schilling sees a deflationary period ahead, one that's bad for companies and citizens in debt, and for other borrowers. "During deflation, it makes it that much harder to pay that debt because companies' revenue is declining or is challenged," Schilling said.

Economists, business executives, and investors alike fear deflation because it robs companies of the ability to increase revenue and hurts the economy's ability to grow. If it takes hold, that's another hurdle policymakers will have to grapple with as they attempt to end the U.S. recession.

In recent comments, U.S. Federal Reserve Chairman Ben Bernanke has talked about "green shoots" in the economy -- initial, modest signs of increasing commercial activity. That's served as an alert to the inflation hawks -- who argue that the massive monetary and fiscal stimulus will soon create problems for price stability in the U.S. economy. However, the hard price data does not support their assertion: during the past 12 months, the Consumer Price Index has fallen 0.4 percent, and the Producer Price Index has fallen an alarming 3.5 percent.

Green shoots are not Sequoias

Further, as Washington Bureau Chief Rex Nutting notes, investors should not overplay the significance of those economic green shoots: they're seedlings, not California Redwoods. The U.S. economy is still very weak fundamentally, Nutting noted, with most evidence showing a contraction, but at a slower pace. By extension, anyone anticipating a rise in inflation driven by a sudden, quantum increase in demand, isn't reading the data Nutting's scrutinized.

"Even though companies might be slowing the pace of firing, they haven't started hiring back in any great numbers," Nutting said. "It could be months or even years before the economy is growing at a pace that will add jobs and improve standards of living."

Further, none of the classic indicators of U.S. demand -- housing, business investment, consumer spending, exports, commodity prices, and stock market market prices -- suggest rising inflation.

And regarding demand in foreign economies, that too has likely taken a deflationary turn. In its revised global economic outlook, the International Monetary Fund said Wednesday it now expects the global economy to contract 1.3 percent in 2009, compared to the previously forecast 0.5 percent contraction.

Another tell-tale stat that the risk is to the downside, not the upside, regarding prices is that in 2008 Japan recorded its first trade deficit since 1980, to about -$11 billion, reported Wednesday. The significance for the United States? Export-dependent Japan is likely to cut prices for new cars that aren't selling -- another act of deflation, and one that will spur other prices cuts if rival, global auto makers exporting to the U.S. do the same to remain competitive.

Economic Analysis: The preponderance of economic data still points to deflation, not inflation, being the real danger for the U.S. economy, at least through this year, and most likely well into 2010. The one wild card remains the price of oil, currently about $48 per barrel, a rise in which can quickly feed inflation into the economy. That said, given the IMF's downward revision for 2009 global GDP to -1.3 percent, that $48 oil price is looking awful heavy. Those facts, combined with analyst Shilling's argument, suggest a period of deflation is ahead, and policymakers must stimulate demand to prevent it.

Financial Editor Joseph Lazzaro is based in New York.

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